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Journalism about foundations, nonprofits and their impact

We’re gradually learning more about the investment performance of foundation endowments.

The news is not good.

The Chronicle of Philanthropy yesterday published my story about foundation endowments. [Paywall] The peg was the Ford Foundation’s decision to publish the investment returns of its $12.1bn endowment for the first time in several years. Ford has done well–its endowment generated 9.2 percent in annual returns for the five-year period ending December 31, 2016.

Most others who manage foundation endowments were not as smart, or as fortunate.

A new analysis of more than 5,700 foundations finds that they generated a median return of 7.72 percent over that same five year period. Most of those foundations employ active asset managers–that is, investment advisors who engage in stock-picking and market-timing, or look to hedge funds, private equity funds or real assets like land, buildings or timber to improve their returns.

Most would have done better to buy a simple mix of low-cost index funds, with 70 percent of their portfolio invested in stocks and 30 percent in bonds. A sample portfolio put together by Vanguard, the index-investing giant, found that the 70-30 mix returned 9.1 percent over that same five years, just a notch behind Ford but well ahead of the median foundation.

The analysis of endowments–which is the most comprehensive ever performed–was done by a startup company called Foundation Financial Research, which can be found at FoundationMark. The company will soon release comparative data about endowments to foundation trustees; if all goes according to plan, that should bring more transparency to the sector, spur competition and improve returns. You can read more about Foundation Financial Research and its founder, John Seitz, in the Chronicle story.

What does this new data tell us? Nothing less than the fact that foundations collectively waste hundreds of millions of dollars, and probably billions of dollars, on investment fees every year. That’s money that, instead of flowing to Wall Street, could and should be given to worthy causes.

To be fair, some foundation are probably not trying to maximize their returns. Their managers may choose safer investments, and give up on bigger gains. (Foundations that are spending down their assets might choose this path.) What’s more, while passive investors have outperformed active investors in the last 5 or 10 years, their returns have been driven in large part by the long bull market in U.S. stocks. When the market falls, active managers or hedge funds could outperform the indexes.

But they probably won’t. There are fundamental reasons to believe that passive investing will outperform active management over the long term, for all but a handful of the best money managers.

The trouble with active portfolio management

For one thing, it’s hard for any asset manager to consistently outsmart the collective wisdom of the many thousands of investing experts who have arrived at a consensus about what any given asset is worth, which is then reflected in its market price. In other words, it’s harder than it has ever been to discover mispriced assets, which is what active managers must do to succeed.

It’s equally hard, if not harder, for foundations to identify the very best active investors, in advance.

Finally, the higher costs of active portfolio managements mean that active managers always will be at a disadvantage when competing with low-cost passive approaches.

Over 10 years, 83 per cent of active funds in the US fail to match their chosen benchmarks; 40 per cent stumble so badly that they are terminated before the 10-year period is completed and 64 per cent of funds drift away from their originally declared style of investing. These seriously disappointing records would not be at all acceptable if produced by any other industry.

About the fees charged by active managers, Ellis writes:

The fees conventionally described as “only 1 per cent” of assets are better seen for what they really are in a 7 per cent return market — 15 per cent of returns.

For foundations, it’s perhaps even worse: The typical foundation that gives away 5 percent of its endowment and spends 1 percent on fees is sending $1 to Wall Street for every $5 that it spends on its operations and gives to nonprofits. Every foundation trustee should ask: Why give up that 1 percent, in advance, to buy advice that will likely prove worthless? Why not settle for being average?

As investment guru Warren Buffett wrote in his latest letter to Berkshire Hathaway investors:

When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.

This is the fourth time I’ve blogged about foundation endowments this year. (See this, this and this for the previous posts.) I’m grateful to The Chronicle for publishing my story. It’s my hope that this reporting will deliver a wake-up call to foundation trustees and CEOs.

I’m interested in hearing from foundations that, like the Central Carolina Community Foundation, have switched from active to passive investing, as well as hearing from proponents of active portfolio management who want to challenge my thinking. There’s more to come on this topic. John Seitz of Foundation Financial Research has promised to release select data on individual foundations and their performance, as their tax returns for 2016 trickle in. I’ll publish some of his findings here on Nonprofit Chronicles and, I hope, in The Chronicle as well.

5 thoughts on “Foundation endowments: The news is not good”

This is definitely an issue worth exploring, although I believe it is more nuanced than what you present here. For most foundations maximizing the return on their endowment is not part of their mission, although they may act like it is. If a foundation’s mission is to combat gambling addiction, should they be investing in companies that promote gambling? If they are committed to human rights, should they be making money on child labor? And, the most obvious one, if they are fighting cancer should they be invested in tobacco companies? I think foundations have the right to decide NOT to make money off of investments in certain companies that are creating or contributing to the problems they are trying to fix. Yes, you can argue that they might have more impact if they could throw MORE money at the problem they are addressing, even if that money is coming from the companies causing the problem. But, that can get into the same issue that you have raised in previous articles about how certain sources of revenue can compromise the mission of nonprofits and create potential conflicts of interest. Lastly, although the Fossil Fuel Free movement admittedly had little if any impact on the fossil fuel free companies themselves, it got the debate about fossil fuels on the table in a lot of places and has clearly raised awareness and contributed to a movement away from fossil fuels. I believe you wrote about that too! I think the issue is a bit more complicated than to just say that foundations could have better endowment returns if they invested passively.

I agree, Kathy, it’s complicated, for a variety of reasons. I do think it’s possible to invest “passively” and yet screen out fossil fuels. It’s not a foundation but Pitzer College recently launched, with BlackRock, a fossil fuel-free index fund. I also very much support foundations doing impact investing.

What I am skeptical about, for all but the biggest foundations, is paying Wall Street money managers to outperform the market. I don’t feel certain about this, but I tend to believe that it’s a fool’s game and the aggregate results for foundations demonstrates that most of them are lagging the markets in the most recent 10-year period. Whether that period is an anomaly, it’s hard to know.

Good day Marc. Thanks for your continued focus on this issue. It is a deep concern to me that so many organizations rely on actively managed investments when the evidence suggests that they do not provide positive investment performance versus a balanced portfolio of index funds. I worry that the promise of better than average returns is rarely tested and that the fees associated with managed funds are neither well understood nor tied in some way to actual performance.

Some organizations have their funds actively managed in house, which seems even more risky as the foundation employee responsible for managing the funds doesn’t even have the level of transparency that Wall Street fund managers have.

I am unsure if this situation is caused by an unwillingness by Boards to break with legacy processes or that there is a belief that active management is somehow a safer or more reasonable option. It may be that Boards’ Investment Committees are simply not equipped with the expertise and feel more comfortable relying on a recognized expert versus a portfolio index fund approach.

> Marc Gunther posted: “We’re gradually learning more about the investment > performance of foundation endowments. The news is not good. The Chronicle > of Philanthropy yesterday published my story about foundation endowments. > The peg was the Ford Foundation’s decision to publish ” >